Rationally Confused: Persistent Responses to Transitory Shocks

In an analytical framework, we study how an economy with rationally inatten- tive firms responds to supply and demand shocks. Firms optimally choose to ignore the nature of shocks in favor of having a better estimate of how those shocks affect their prices. As a result, in our economy, when firms get signals that they should increase their price, they are confused about whether the underlying shock is a positive demand shock or a negative supply shock. This has significant implications for monetary policy: we prove that if monetary policy shocks are not persistent enough, every expansion caused by a positive policy shock will lead to a recession as firms would interpret it as a negative supply shock. This favors policies such as interest rate smoothing.